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Another Look at Estimating Reliable Profit Indicators IN tRANSFER pRICING

Posted by Ednaldo Silva

We take another look that computing profit indicators using restricted data samples can lead to unreliable measures of arm’s length taxable income to benchmark controlled inter-group transactions. To produce reliable measures, we must change the pervasive transfer pricing practice of considering three-years of data, and consider as many data points as available.

We consider in our example the current and historical operating profit margin after depreciation of Walmart (GVKEY 11259). In Capital IQ (Compustat) mnemonics, operating profit after depreciation is called OMAD, which is also known as EBIT margin.

If Walmart is regarded to be comparable to a controlled tested party under the TNMM (CPM in the United Sates), computing its three-year median is not sensible because the series of OMAD reveal a high polynomial behavior; therefore, slicing any three years of data produces unreliable measures of Walmart’s OMAD.

To visualize our concern with computations of three-year quartiles, we plotted two curves of Walmart’s historical OMAD. The first chart shows that the OMAD series is not stationary, and that we need a higher than cubic polynomial to obtain a good fit for Walmart’s declining OMAD trend. The last three years (2018, 2017 and 2016) show an abnormal OMAD pattern--that is, a cluster of three-year data points lower than the prior historical nadir. The second chart shows one-period differences in OMAD, which results in a near-stationary series. The third chart shows the behavior of the operating profit markup, which we estimated using equation (1) below, with increasing sample sizes, starting with three years of data and ending with 41 data pairs. On chart three, the solid red line is a Lowess curve showing the number of data years required for the estimated operating profit markup to settle down to a stable value.

To continue our example, using regression analysis, we estimated two long-term measures of Walmart’s operating profit markup from which we can obtain the corresponding OMAD. The dependent variable S(t) is Net Sales in year t, and again using Capital IQ (Compustat) mnemonics, the independnet variable C(t) = COGS + XSGA + (DP – AM) is Total Costs, including depreciation (DP) but excluding the amortization of acquired intangibles (AM). The variable U(t) is the residual error.

We considered Walmart’s 41 annual total costs and net sales ordered pairs from 1978 to 2018:

     (1)     S(t) = 1.0504 C(t) + U(t)

with the Newey-West t-statistics = 289.8 and R2 = 0.9999. The intercept is insignificant, which we regard as zero.

We estimated also one-year-differences in variables, and obtained:

     (2)     ∆S(t) = 1.0604 ∆C(t) + V(t)

with the Newey-West t-statistics = 59.2 and R2 = 0.9925. The intercept disappears with differencing the dependent and independent variables.

Markup pricing model (1) is found in Kalecki (1954). Newey-West t-statistics means that we computed HAC (Heteroskedasticity and Autocorrelation Consistent) standard errors. See Green (2018), Section 20.5.2, pp. 998-999.

Regression (1) produces a long-term OMAD = 4.8%, and regression (2) produces an OMAD = 5.7%. Again, note that this measure of operating profit margin excludes AM from the numerator. Measured by the higher Newey-West t-statistics, regression equation (1) shows stronger (more reliable) results. See https://blog.royaltystat.com/profit-margin-in-the-markup-pricing-model

An important rule-changing implication is that we must select profit indicators with a clear theoretical underpinning (e.g., Kalecki (1954)), and we must consider many years of data available for each selected comparable. The regression estimates of operating profit indicators using larger data samples produce more reliable arm’s length ranges of near-neighbor values than the computation of quartiles using three years of data. 

REFERENCES

William Green, Econometric Analysis (8th edition), Pearson, 2018.

Michael Kalecki, Theory of Economic Dynamics, George Allen & Unwin, 1954. Reprinted in Michael Kalecki, Selected Essays on the Dynamics of the Capitalist Economy, Cambridge University Press, 1971, Chapter 5 (Costs and prices). An earliner version of the markup pricing equation was published in Michael Kalecki, Studies in Economic Dynamics, George Allen & Unwin, 1943, Chapter 1 (Costs and prices).

 

Time Series Plot of OMAD

Time Series Plot of OMAD Differences-1

Scatterplot of Markup vs Count-1

 

Published on Oct 19, 2019, 3:05:09 PM

Ednaldo Silva (Ph.D.) is founder and managing director of RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

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Topics: Net Profit Indicator